Another Look at P/e Ratios

Whereas the relations derived for price-earnings (P/E) ratios predict a positive relation with future earnings growth and negative relations with interest rates and risk, prior empirical investigations of the determinants of P/E ratios find these links to be weak. One reason commonly offered for this apparent inconsistency is the presence of transitory earnings components in the denominator. We show how switching from trailing P/E ratios to forward P/E ratios, by substituting next year’s forecasted earnings for the prior year’s reported earnings, makes the predicted relationships more evident. We also find that forward P/E ratios are related to the volatility of reported earnings: both lower cash flow volatility and the reduction in volatility due to accruals that convert cash flows to reported earnings are associated with higher P/E ratios. Even though reported earnings volatility does not appear in the relation derived for forward P/E ratios, we find an indirect connection: firms with lower cash flow volatility and greater earnings smoothing due to accruals are strongly associated with higher growth forecasts (the links with lower risk are not as clear).